Oct. 23 (Bloomberg) -- Federal Reserve Chairman Ben S.
Bernanke is trying to inject a little of the exuberance his
predecessor Alan Greenspan called “irrational” into markets
for everything from stocks to housing.

Bernanke, who is seeking to spur the economy with a third
round of so-called quantitative easing, has said his stimulus
works by lowering borrowing costs and encouraging investors to
seek higher-yielding assets. Boosting home and equity prices
through bond buying will encourage consumers and businesses to
spend more, according to Bernanke.

Since these are the same assets that plummeted during the
financial crisis after reaching record highs, “is there some
risk you could start a new bubble and repeat the whole cycle? I
suppose there is,” said Robert Shiller, the Yale University
professor who forecast the end of the Internet boom in his book,
“Irrational Exuberance,” which was published in March 2000,
the month the Nasdaq Composite Index peaked before crashing 78
percent.

Bernanke’s approach risks “distorting” decisions, and
“it might be economically inefficient to try to push prices up
so much,” Shiller, who also predicted the bursting of the
subprime-mortgage bubble, said in a New York interview Oct. 15.

‘Distort’ Allocations

While Federal Reserve Bank of New York President William C.
Dudley acknowledged that current policy “could distort asset
allocations and lead to renewed financial-asset bubbles,” this
isn’t a risk now, he said in an Oct. 15 speech.

“There is little evidence of problems or excesses, but
this could change as the recovery proceeds,” said Dudley, who
is also vice chairman of the policy-setting Federal Open Market
Committee.

If these risks climb, they will need to be factored into
the committee’s decisions, and Fed officials will “examine what
steps could be taken on the macro-prudential front in
response,” he said.

In answering audience questions, Dudley said the Fed’s
policies are affecting yields in the bond market, though “to
say that’s a bubble, I don’t think that’s quite right.” He
added that the debt market is a “lever of policy” for the
central bank. The Fed’s asset purchases helped drive yields on
the benchmark 10-year Treasury note to a record low of 1.38
percent on July 25. The yield was 1.81 percent on Oct. 22.

Rising Index

The Standard & Poor’s 500 Index reached 1,465.77, the
highest since 2007, on Sept. 14, the day after the FOMC said it
would buy $40 billion of mortgage-backed bonds a month without
limiting the total or duration of purchases. The index is up
about 109 percent since hitting a nadir in March 2009.

Home prices also have begun to rise, jumping in the second
quarter by the most in more than six years, according to the
S&P/Case-Shiller index, a real-estate benchmark of property
values in 20 cities that Shiller created with Karl Case, a
professor emeritus at Wellesley College in Massachusetts.

Fed policy makers are meeting today and tomorrow in
Washington.

The Fed’s large-scale asset purchases probably will lift
stocks by 3 percent in the two years following the Sept. 13
announcement of QE3, as low yields on government bonds push
investors into riskier assets, according to a Sept. 27 report by
Deutsche Bank AG economists. They also estimate the new stimulus
will lift home prices by 2 percent in the same period, assuming
the Fed maintains purchases of Treasuries and mortgage debt
through 2013.

Perfect Knowledge

“How do they know whether or not these prices will prove
to be justified in the long run?” said John Lonski, chief
economist at Moody’s Capital Markets Group in New York. “The
Fed doesn’t have perfect knowledge about what constitutes a
sound long-term price for equities or housing, but this is a
risk the Fed is willing to take.”

Lonski said potentially inflated asset prices could prove
“devastating” if the Fed is forced to tighten policy quickly
or mistimes its exit from record monetary stimulus. The Fed has
had “less than perfect” timing in the past, he said.

Greenspan’s “irrational exuberance” comment in 1996
wasn’t actually timely: When he spoke, the Dow Jones Industrial
Average was above 6,400. It peaked at over 11,700 in January
2000, before technology stocks crashed. In May of this year,
Greenspan said stocks are “very cheap” and likely to rise.

Slumping Dow

The Dow slumped 1.6 percent to 13,127.64 as of 1:15 p.m.
today in New York, heading for the biggest loss since June amid
disappointing results at companies from 3M Co. to DuPont Co.,
both of which are components in the 30-stock gauge.

The broader S&P 500 lost 1.3 percent to 1,415.70. The
benchmark for American equities has been trading at a valuation
of 14.2 times reported earnings, compared with a six-decade
average of 16.4 times, according to data compiled by Bloomberg.

Critics blame Greenspan for inflating the housing bubble by
holding the Fed’s benchmark interest rate too low for too long,
slashing it to 1 percent in late June 2003 and keeping it there
for a year.

Bernanke has relied on unorthodox stimulus such as
quantitative easing to reduce borrowing costs after cutting the
federal funds rate to near zero in December 2008. The latest
steps have succeeded in making home mortgages less expensive,
with the average fixed rate offered on new 30-year loans at 3.49
percent on Oct. 22, down from 3.57 percent Sept. 12, the day
before the last FOMC meeting, according to Bankrate.com data.

Willing Spenders

QE3 is designed to boost “Main Street,” the Fed chairman
said at a Sept. 13 press conference after the Fed announced the
measure. “Many people own stocks directly or indirectly,”
Bernanke said. “The issue here is whether or not improving
asset prices generally will make people more willing to spend.”

The S&P 500 has risen about 0.7 percent since Bernanke set
the stage for a third round of bond buying in an Aug. 31 speech
in Jackson Hole, Wyoming.

Allen Sinai, president and chief executive officer of
Decision Economics Inc. in New York, says the stock-market
effect is “underrated.” He estimates that a 20 percent gain in
the S&P 500 can add as much as 1 percentage point to U.S. growth
with a one- to two-year lag.

The Fed’s third round of quantitative easing could be more
powerful for stock prices than previous rounds because the open-ended policy is contingent on higher employment and stronger
economic growth, assuring better earnings, he said.

Stronger Growth

“It is as if the Federal Reserve has promised to keep on
reducing the federal funds rate until the economy grows at a
higher rate,” Sinai said. Persistent Fed stimulus means “I can
expect stronger growth, and stronger growth should mean higher
earnings, and I can buy stocks.”

Fed Governor Jeremy Stein questioned in an Oct. 11 speech
whether companies would take advantage of record-low borrowing
costs to invest in equipment and software or simply buy back
stock and pay dividends.

Investment-grade corporate bonds with an average maturity
of more than 10 years yielded a record low 2.76 percent on Oct.
15, according to index data compiled by Bank of America Merrill
Lynch. Investment-grade issuance in the U.S. has topped $900
billion in 2012, already exceeding all of last year’s borrowing,
data compiled by Bloomberg show.

As corporate bond yields fell and issuance rose, total
dividend payments jumped to $275.8 billion in the four quarters
ending Sept. 2012 compared with $247.3 billion in the previous
four quarters, according to data gleaned from Securities and
Exchange Commission filings by FactSet, a data-analysis company
in Norwalk, Connecticut.

‘Very Seriously’

Stein also said the possibility that Fed policies are
causing banks, insurance companies and pension funds to take on
more risk as they try for higher returns “should be taken very
seriously.”

“A short summary would be that there is some qualitative
evidence of reaching-for-yield behavior in certain segments of
the market but that we are not seeing anything quantitatively
alarming at this point,” Stein said. “The worry is that one
often sees only the tip of the iceberg in these kinds of
situations, so one needs to be cautious in interpreting the
data.”

Yields on high-yield, high-risk securities also have
fallen, to a record low of 6.84 percent on Oct. 18, Bank of
America Merrill Lynch index data show.

If Fed policy makers “just keep buying assets, the price
of assets will go up in a big way because they want to do a huge
amount every month,” said Jagdish Bhagwati, a professor of
economics at Columbia University in New York whose former
students include European Central Bank President Mario Draghi
and International Monetary Fund Chief Economist Olivier
Blanchard.

“That also has a downside because it can lead to a bubble;
that’s exactly what we should be worried about,” Bhagwati said.
“Creating bubbles is not a risk-free thing.”